Fund Facts
I can spend hours, days even, pondering whether to buy a certain pair of shoes. But the big stuff? I was decided on our house in about 10 minutes. I’ve bought three cars in my life, all sight unseen from an online dealer on the other side of the planet. Apparently, the importance or size of a purchase has no correlation to the amount of effort I bring to the buying decision.[1]
So, I really should not be at all surprised that when I ask a client how they chose the funds in their investment portfolio, the answers consistently fall along these lines:
“My [insert family member who is usually male] said it was a good idea.”
“I read about it on social media.” (Related: “I heard about it on a podcast.”)
“I really don’t remember.”
I’m not complaining exactly. After all, I am a financial planner; my job is to help clients choose their investments. If everyone made rational, well-considered investment decisions on their own, I might be out of work.
Whether within an employer 401(k) account, or your own brokerage account, you will likely be faced with a moment when you must choose an investment. Whether by choice or circumstance, you may be making that selection on your own.
The larger questions — the right proportion of stocks versus bonds in your portfolio, for example — are not the topic of this particular blog. Today, I am picking up the tale at the point where you have decided to buy a stock (aka equity) fund and are trying to decide which one.[2] Specifically, you are gazing at the webpage of your preferred investment firm and wondering what to do with all of that information on the screen. What are the most essential terms and jargon that you need to understand in order to make a reasonably informed choice?
Is it a mutual fund or an exchange-traded fund (ETF)? I will work from the assumption that you are aware that a mutual fund is a basket of many different stocks. ETFs work pretty much the same in the ways that would likely be of concern to you.[3] With that said, ETFs are usually a bit less expensive to buy (more on that later) than a mutual fund with identical holdings. If you are seeking a plain-vanilla equity fund that tracks a broad market index, such as the S&P 500, then there is likely an ETF version available.
Is it an actively managed fund or a passive index fund? Oh, this is my favorite question. It could be an entire blog on its own (and probably will be in the future). So that we are all on the same page, an actively managed fund (which could be either a mutual fund or an ETF), is one where a human being decides which stocks to hold based on their professional judgment. A passive index fund or ETF simply holds all of the stocks that comprise the market index upon which it is based (such as the S&P 500).
Because our time is short today, I will cut to the chase. Literally decades of research consistently return the same result: Actively managed funds do not outperform index funds and cost you a whole lot more to buy.
Which index does the fund follow? The S&P 500 is a common broad market index; it is an index of the stocks of the largest 500 publicly traded firms in the US. But there are many other indexes. The Morningstar US Total Market Index tracks the performance of the entire US stock market. The Russell 2000 Growth Index is comprised of the stock of just small US companies. You may encounter something like the FTSE Global All Cap Index, which tracks stocks in companies across the globe (including the US).
The questions for you are:
“Does the index (upon which this fund is based) match what I am trying to achieve?”
“Does this one fund contain all that I want, or do I need to buy more than one fund to achieve my investing objective?” For example, you may very rightly want to hold stock in both US and non-US companies. Some funds will have both; others, just one or the other.
What does this fund cost? That brings us to the expense ratio. This will be displayed prominently (one hopes) as a percentage. It is the amount that you pay annually as a fee to the investment management company for the fund you are purchasing.
The math works like this:
An expense ratio of .03% (common for a low-cost index ETF) means that for every $10,000 you have invested, you will pay $3. So, if your balance is a healthy $100,000, your annual cost for the fund you have chosen is $30.
Where it gets interesting is when you project out the cost of fees over time and see how this impacts your investment balance. This is a great calculator for that purpose. If you do not believe that cost matters, it will make a believer out of you.
How does the fund perform versus its benchmark? This is a bit of a trick question. If a fund by its design only holds the companies in the S&P 500 index, its performance (investment return) should closely match its benchmark index…the S&P 500.
I raise the question to highlight that when choosing a fund, many people will home in on the nice chart that shows recent market performance, perhaps to the exclusion of everything else. The performance of a fund (or any investment really) is only relevant if you have something to compare it to. Oh, the number of times someone has said to me that their advisor is an investing whiz because their portfolio is up X%...in a market where everybody’s portfolio is up X%.
That aside, don’t just look at the last year. Consider the performance of the fund over the last three, five and ten years. Not because you expect the fund to outperform the market — we’re still talking about an index fund. But because your expectations need to be in order. Don’t assume that the awesome stock market returns of the last few years (save 2022!) will persist, or that your road to investment riches will be a smooth and unblemished path.
What the %^$ is beta? You know I could not resist throwing in a bit of 201-level curriculum. Very simply put, beta is a mathematical expression of how “risky” the fund is, as compared to the overall market. (The “overall market” will be measured by a very broad, all-encompassing index, such as the Dow Jones US Total Market Index.) It is a measure of a fund’s sensitivity to changes in the broader market.
A fund with a beta score of 1.0 means that the fund’s performance is no more or less risky than the market as a whole. So, you should expect an S&P 500 index fund to have a beta pretty close to 1.0.
However, an index fund that is comprised of just small company stocks for example, is likely to be “riskier” and will sport a beta higher than 1.0, perhaps 1.29. That means that this fund is likely to have a higher return than the market average when overall stock market prices are going up…but also have a lower return than average when the market is heading down. Beta is a measure of volatility and it cuts both ways.
Similarly, you may see an index fund with a beta of less than 1.0, perhaps .68. This would be typical of an index fund that sports the moniker “value fund.” The price of a fund such as this is less volatile than the market as a whole, e.g., it is less “risky.” Its price won’t go up as much as the market average when times are good, but then again, the price will likely not fall as much in bearish conditions.
[1] Not a recommendation!
[2] You have decided to buy a fund. Not an individual stock.
[3] Yes, there are differences. I’m just saying that for the average investor, these differences are not especially meaningful (except for price).
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